The Economics of Tailored Regulation and the Implications for Project XL

Project XL is an example of a new environmental management approach called "tailored regulation" (TR) wherein firms volunteer to negotiate site-specific, performance-based pollution control agreements with regulators and community stakeholders. Though the current administration has touted it as a "regulatory blueprint for the future," XL has often floundered, in part because no theoretical analysis exists to guide policy design. The objective of our proposed research is to develop an economic theory of TR, in order to describe the conditions under which it is to be preferred to command and control and economic incentive instruments, and to generate recommendations for designing and implementing it.
Approach:
Our research will consist of seven tasks. First, we will develop a "baseline" mathematical model to illustrate the benefits of TR. Second we will review relevant analytical literatures. Third, we will develop two analytical models that incorporate the real-world characteristics such as uncertainty, imperfect information, and rent seeking that are likely to affect the social benefits of TR. The first model will focus on the market structure and dynamic investment issues, and the second on information-theoretic and bargaining issues. Fourth, using data we have already collected, we will conduct an empirical analysis of XL projects to complement the analytical models. Fifth, we will analyze the overall strengths and weakness of TR. Sixth, we will draft a list of recommendations for designing and implementing TR. And finally, we will describe areas for future research.
Expected Results:
Intuition suggests that we may find the following. First, TR has the potential to improve efficiency by according firms more control over technology choice, creating incentives to innovate, and improving the regulator's ability to monitor. TR may even be preferable to economic incentive instruments when monitoring and transactions costs are high. However, TR may favor large firms in mature industries and those with special relationships with local stakeholders. This would be undesirable if it discouraged the participation of firms likely to have innovative pollution control strategies, impeded competition, or exacerbated rent seeking, but would be desirable if it sparked races to secure TR agreements. It should be possible to mitigate TR's undesirable impacts and magnify its desirable ones by carefully structuring program rules governing participation, the allocation of participation costs, and negotiations. For example, the regulator could encourage small or innovative firms to participate by limiting participation in some industries to better enable firms to appropriate the benefits of TR.

Objective: Launched with considerable fanfare in November 1995, EPA's Project XL is the nation's preeminent example of a new environmental management approach called "tailored regulation" (TR). TR has five defining characteristics: it is facility-specific, voluntary, performance-based, involves stakeholders in negotiating regulatory agreements, and emphasizes diffusing regulatory innovations among nonparticipating firms. TR has been touted as a means of mitigating well-known inefficiencies associated with command-and-control regulations. Although there are good reasons to support further implementation of TR, there also are a number of potentially serious problems. Thus far, two such problems have received virtually no attention: Might negotiating regulatory agreements with hundreds or thousands of individual facilities prove prohibitively costly? and, Might TR have adverse intra-industry competitive impacts by allowing participating facilities to operate under a different set of guidelines than nonparticipants? The objective of this project was to investigate these problem areas.

Summary/Accomplishments:Empirical Research on Transactions Costs. The broad question this research addressed was, What can we learn from Project XL about the transactions costs associated with TR? The specific questions it addressed, along with a summary of our findings, are discussed below. The data for this study came from a fall 1998 telephone survey administered to a sample of representatives of facilities and EPA regional offices involved in negotiating XL agreements. In addition, we used publicly available data on the sample facilities.

What is the magnitude of the transactions costs associated with project development? The average transactions costs for our sample facilities were $350,000. Average transactions costs for the EPA regional offices were $110,000. Thus, total average per project transactions costs were $460,000. We used the cost data to divide our sample into two groups?"high-cost" projects and "low-cost" projects?based on whether the transactions costs associated with each project were above or below the sample median ($540,000).

What stages of the project development process are perceived as being the most costly? To address this question, we divided the project development process into six stages and asked each of our survey respondents to tell us what percentage of transactions costs arose in each of these stages. The key finding is that for the entire sample, about half of transactions costs arose from interacting with EPA regions and from obtaining final approval from EPA headquarters, while only about one-fifth of transactions costs arose from stakeholder negotiations. The high-cost firms spent more time obtaining final approval than the low-cost firms. Thus, the bottleneck for high-cost firms appears to have been obtaining final approval.

What issues associated with the project development process are the most costly? To address this question, we compiled a list of the issues most frequently mentioned in the literature as sources of transactions costs and asked our survey respondents to rank them. The issues most often chosen as "most important" by facilities and EPA representatives concerned unclear guidelines governing "superior environmental performance" and a lack of coordination among EPA offices. Thus, EPA management was identified by our respondents as being the most important source of transactions costs.

Why are transactions costs higher for some facilities? To address this question, we collected publicly available data on 23 characteristics of our sample facilities and their proposals, and then we looked for correlations between these characteristics and the magnitude of transactions costs. We found that differences in the complexity of proposals?not the characteristics of the facility, firm, or negotiating process?drove differences in transactions costs across firms. Every one of the facilities in the high-cost category requested either an agreement covering more than one facility, or a waiver of the requirement to get new air permits every time the production process changes (in exchange for an aggregate cap on air emissions). By contrast, none of the facilities in the low-cost category requested such a waiver, and only one submitted a proposal involving more than one facility.

Policy implications. What do our findings imply about the viability of Project XL and, more broadly, the viability of TR? They constitute "good news" in some respects and "bad news" in others. The good news is that, although we found that the costs of project development have been significant, our survey results indicate that the one part of the process that many critics have identified as potentially most costly and most difficult to manage efficiently?stakeholder negotiations?has not been a major component of costs. Rather, a considerable percentage of costs have been due to problems with EPA's management of the initiative.

Our results constitute bad news as well. We found that the complexity of the project proposal may well have been the key determinant of project development costs. To the extent that complexity is correlated with innovation?and judging from our sample there does appear to be a strong correlation?this implies that innovative proposals are likely to be the most costly. This does not bode well for EPA's prospects of remedying an often-cited weakness of Project XL: its inability to attract proposals that, if transferred, could have a significant impact on the efficiency of the regulatory system as a whole.

A second troubling implication of our findings is that, given that participating in Project XL has been costly and that pushing through the most beneficial type of project agreements has been especially costly, one would expect the initiative to be biased in favor of large firms. Such firms have financial and human resources and economies of scale and scope that lower the costs and increase the benefits of participation relative to smaller firms. The fact that virtually all of the firms in our sample are relatively large (see Table 7 in Blackman and Mazurek, 2000) confirms this hypothesis.

The policy prescriptions that flow from these conclusions are straightforward. To achieve either the ambitious goal of making Project XL a viable "regulatory blueprint" for site-specific regulation, or the less ambitious objective of ensuring that it serves as an effective test-bed for policy innovations, EPA must clearly demonstrate that the cost of project development can be reduced for innovative proposals as well as prosaic ones, that small firms can participate, and that the benefits of regulatory innovations can be transferred.

Our study also suggests that given the need to find ways of reducing the costs associated with developing XL projects, EPA would benefit immensely from developing reliable mechanisms to track costs?both those incurred by firms and by the EPA. As yet, there is little public information available, and very little analysis of the costs incurred by EPA headquarters.

Theoretical Research on Competitive Issues Associated with TR. This research used an analytical economic (Cournot Duopoly) model of the interactions among a regulator and firms to determine whether widespread implementation of TR would necessarily improve social welfare. This model generated three key results.

1. Transactions costs constrain welfare improvements. The higher are transactions costs, the harder it is for the regulator to generate participation in TR and to motivate superior environmental performance. The logic behind this result is simple: given fixed transactions costs, to get firms to participate, regulators must offer TR agreements that lower production costs. Moreover, the higher are fixed transactions costs, the larger must be the production cost reductions. But when the regulator is forced to offer relatively large production cost reductions, there is less leeway to set high environmental performance standards. 2. TR can reduce welfare via "market stealing." It is theoretically possible for a TR agreement to reduce welfare by reducing total industry profits. This can happen because of a phenomenon known as "market stealing." To understand this phenomenon (which is well-known in the industrial organization literature), imagine a sector comprised of just two firms with identical market shares. One of them gets a TR agreement and one does not. The market share and the profit of the firm that gets the TR agreement goes up and the market share and profit of the firm that does not goes down. The firm that gets the TR agreement is the "winner" and its rival is the "loser." TR's impact on total industry profits will be negative when the winner's gain is smaller than the loser's loss. This happens when the winner is "less efficient" (has a lower profit margin) than the loser. Essentially, one can get a welfare loss when TR agreements are given to inefficient firms that profit at the expense of efficient ones (and when this social cost is larger than the gain in consumer surplus). That may seem like a far-fetched story, especially because most firms that participate in Project XL?our TR prototype?are large market leaders that are not likely to be inefficient (see Blackman and Mazurek, 2000). But the possibility of TR leading to welfare losses via market stealing is far less remote when one takes into account the diffusion of TR agreements. 3. Diffusion of TR agreements may entail costs as well as benefits. We model the diffusion of TR agreements as the ability of firms that do not formally participate in TR to get the same TR agreements that participants get without paying the fixed participation cost. In such situations, diffusion has two important disadvantages. First, it can reduce industry profits via "market stealing" even if only efficient firms participate formally. The reason is that the regulator is essentially giving a competitive advantage to relatively inefficient firms. Second, diffusion dampens incentives for firms to formally participate. Clearly, if firms can get the benefits of TR via diffusion, they have less incentive to participate. There is a strong analogy to firms' incentives to invest in developing new products. Such incentives are dampened when firms know that their rivals can appropriate the fruits of their investments (this is the basic argument for patents).

Policy implications. Our findings suggest that regulators can ensure that TR attracts participants and enhances welfare by carefully choosing which firms can participate, the cost savings offered to each firm, and the extent to which TR agreements are allowed to diffuse to nonparticipating firms. With regard to the selection of firms and the terms of the agreement, the regulator can avoid welfare losses by ensuring that relatively inefficient firms are not singled out for participation or particularly advantageous agreements. Even if this strategy can be successfully implemented, it has an important drawback: it implies that regulators should provide cost-breaks to market leaders, a policy that smacks of inequity and would likely run into stiff political opposition. Moreover, such a policy could result in the exit of smaller firms and increased market concentration. We have focused on demonstrating how TR can have adverse welfare impacts even abstracting from exit. Nevertheless, intuition suggests that while TR administrators should ensure that inefficient firms are not the principal beneficiaries of the TR regime, they also should ensure that efficient firms are not helped to such an extent that their competitors are forced to exit the market.

Happily, in practice, even if regulators do not actively select relatively efficient firms to participate, political-economic considerations are likely to favor their participation. With in-house environmental management and lobbying capabilities and relatively easy access to investment capital, large market leaders (which are presumably relatively efficient) can more easily pay the fixed cost of participation in TR. The Project XL experience thus far would appear to confirm this hypothesis. Does this mean that regulators can ignore the threat of welfare losses due to market stealing? Probably not. TR's emphasis on the diffusion of TR agreements among nonparticipants implies that inefficient firms need not formally participate in TR to steal market share from their competitors?market stealing that results from diffusion may lead to welfare losses.

Hence, from the point of view of social welfare, the regulator's diffusion policy is critical. Diffusion has a number of potential costs. We found that it can lead to welfare losses from market stealing, and can also dampen firms' incentives to participate. In some situations, when diffusion is costless, it may not be possible to induce participation no matter how attractive the terms of the TR agreement. Therefore, the regulator may want to limit diffusion to both prevent market stealing and to generate formal participation. Widespread formal participation has clear advantages. It always has a positive impact on consumers' surplus and?assuming that performance standards under TR are more stringent than under command-and-control?on the environment.

But diffusion of TR agreements clearly has economic benefits as well. It reduces firms' marginal costs and therefore inevitably enhances consumers' surplus. This benefit may be sufficient to offset any potential loss in producers' surplus. Hence, in setting a diffusion policy, the regulator must balance potential welfare benefits against costs. This calculation is likely to vary across industries.

Finally, our findings highlight the desirability of minimizing the fixed costs of participating in TR. Given that TR agreements must reduce operating costs to induce participation, there is clearly a trade-off between the amount of cost-reducing regulatory flexibility an agreement entails, and the amount of environmental benefit it requires. But we have seen that lower participation costs imply that regulators can induce participation with less attractive offers. Therefore, one means of allowing for more of each type of benefit is to find ways of reducing the fixed costs associated with participation. Although we have modeled fixed participation costs as exogenous, in practice, regulators should have some control over them. For example, in the case of Project XL, empirical research has indicated that management problems at EPA as well as uncertainty about the statutory foundation of the initiative are key contributors to participation costs, so it seems reasonable to assume that regulators have some ability to reduce these costs.

Changes in Research Plan. In our original January 15, 1997, proposal, we envisioned seven tasks. Of these tasks, we essentially completed five. We developed two analytical models?although only one was brought to fruition (task iii); conducted an empirical analysis of Project XL (task iv); developed recommendations for designing and implementing TR (task vii); reviewed the relevant analytical literatures (task ii); and developed a list of future areas for research (task vii, see below).

During the course of the project, our research plan was modified in a number of respects. Most important, the analytical modeling component of the project (task iii) proved considerably more difficult, time-consuming, and expensive than anticipated so that funding was inadequate to complete all of the tasks originally envisioned. As discussed in the proposal, ours is the first attempt to develop a rigorous analytical model of TR. As is always the case with this type of research, we pursued a number of "dead ends" before settling on what we felt was the most appropriate model. For example, a good deal of the theoretical effort in the first year of the project was devoted to constructing a model that had as one of it principal features bargaining between firms and regulators. Ultimately, we decided this framework would not enable us to address the issues of greatest concern to policy makers, and would not stand on its own as an independent model in part because there already is considerable economics literature on bargaining in environmental regulation. Therefore, we abandoned this bargaining model in favor of the model presented in Blackman and Boyd (2000).

In general, we focused our resources on those tasks we felt were most important. For example, regarding the strengths and weakness of TR vis a vis command-and-control and economic incentives (task v), Blackman and Boyd (2000) address in detail the advantages and disadvantages of TR vis a vis command-and-control, the predominant form of regulation in the United States and worldwide. Most of the issues raised by the simple diagrammatic model presented in our January proposal (task i) are embedded in the model presented in Blackman and Boyd (2000).

Regarding the use of the empirical study to test the predictions of the analytical model (task iv), for a number of reasons we were unable to complete this in the manner envisioned. Given time constraints, we undertook the empirical and analytical components of the project simultaneously instead of sequentially. However, we did devote considerable effort to finding evidence of the effects of TR on intra-industry competition. We tested for and confirmed the hypothesis that TR is likely to attract large market leaders. Unfortunately, we were unable to make much progress in finding evidence for adverse competitive impacts. One important reason is that, at the time we conducted our survey, fewer than 20 XL projects were being implemented.